Investing in Commodities: Don't Forget to Diversify

You are exposed to a number of unpredictable factors when you elect to start investing in commodities. When you purchase stock in a corporation, annual reports and financial statements can generally provide an indication of if and when a price may fall. Of course, there is always risk involved, but market indicators are there to guide you. With commodities, you are dealing with an actual physical trade. This relies on the quality of the item being traded, which can easily be compromised in an instant. 

Perishable Commodities

Perhaps the greatest example of exacerbated risk in commodities investments is the trade of perishable goods. When you are attempting to trade an item such as soy, corn or fruit, you are at the mercy of a large number of factors such as weather, agricultural health, trade routes and middlemen. One late freeze can compromise your tomato trade. One delayed ship can cause your corn to spoil. This type of risk applies not only to the physical traders of the commodity but to anyone invested in futures, options or any form of derivative-based trading using the price of the commodity as a benchmark. When this happens, you will be thankful you are diversified in other commodities and stocks to protect yourself from total loss. 

Price Fluctuation

Due to factors such as those discussed above and many other unpredictable factors, the price of commodities can range very widely in a very short period. Price fluctuation is part of what makes commodities trading so profitable when done correctly. A trader who can anticipate price changes can profit from them. This is also what exposes investors to a number of risks, however. For example, the price of oil is largely dependent on the political climate surrounding production by the Organization of Petroleum Exporting Countries (OPEC). When OPEC is pressured into raising production, the price of oil you are holding may drop suddenly. If you were invested solely in petroleum or an oil-based trading model, such as refined oil, you would stand to lose large sums of money. Diversification will save your portfolio until the commodity turns around.

Storage and Transport

Even nonperishable commodities, such as gold and diamonds, must be stored, transported and otherwise kept safe in order to be traded. With stock, you are trading a piece of paper called the stock certificate. Transfer of this paper happens electronically for the most part, but if it should ever need to be delivered fully, the cost to do so is low. With commodities, the cost to potentially fully deliver a product can be astronomical. If you are investing in a commodity, though, you are essentially promising to arrange for receipt or delivery of the product if necessary. Because the logistics of commodities trading is complicated, even if we never see it occur, the costs associated with commodities trading can be unpredictable. This can lead to a loss where you anticipated a gain. Investing in a simpler, less risky trading model in addition to a commodities investment will save you money in the long term.

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